7. Market failure

Question 1

Market failure

Answer 1

• economic situation defined by an inefficient distribution of goods/services in the free market
• a steady state of disequilibrium in which the quantity supplied does not equal the quantity demanded

Question 2

what is the correct function of a market?

Answer 2

• to efficiently allocate resources based on what people want, and the relative difficulties of producing those things
• something desirable and cheap (water) should be produced a lot
• something undesirable and expensive almost not at all
• something desirable but expensive in smaller quantities…

Question 3

price mechanisms

Answer 3

producers out prices high enough to cover their cost and make some profit but low enough to compete

Question 4

what is a classic example of imperfect competition

Answer 4

a natural monopoly - e.g. tap water - it makes sense to have just one company providing tap water because there are very high capital costs involved in setting the business up – if there were two of them the prices of water would be very high

Question 5

how can G reduce the power of a monopoly

Answer 5

1) using legal measures to make the market more competitive - making mergers and takeovers more difficult to achieve
2) setting up regulatory bodies (Agency for the Protection of Market Competition) also called monopolies watchdogs - taking action if they feel that the public interest is being harmed

Question 6

rivalrous and excludable meaning

Answer 6

rivalrous - consumption by one person reduces availability for someone else
excludable – people can be excluded from using good (usually because of price)

Question 7

are private, public and quasi-public goods rivalrous and excludable?

Answer 7

Private goods – rivalrous and excludable (groceries, airplane tickets, phones…)
Public goods – non-rivalrous and non-excludable (police force, national defense)
Quasi-public goods - non-rivalrous but excludable (museums, toll roads (exclude those that can’t pay))

Question 8

what is the free rider problem?

Answer 8

• arises due to non-excludability
• a good can’t be excluded so private firms don’t make it (resource misallocation)

Question 9

how do G fix the free rider problem?

Answer 9

1) providing the goods themselves (national defense, flood barriers) – the use of taxes to fund the provision spreads the cost over a large number of people who would not be prepared to pay individually
2) subsidizing private firms, covering all of the costs, to provide the goods

Question 10

Merit goods

Answer 10

• goods that are considered to be of benefit to society (education, health care, sports facilities - all public goods)
• underprovided by the free market and therefore also under-consumed
• their underprovision is considered to be a market failure

Question 11

how does G reduce the MF linked to merit goods?

Answer 11

1) direct provision of more important merit goods
2) subsidizing the production of less important merit goods

Question 12

Demerit goods

Answer 12

• goods that are considered harmful to society (child pornography, hard drugs, cigarettes, alcohol)
• over-provided by the free market, and therefore also so overconsumed
• their overprovision is considered to be a market failure

Question 13

how does G reduce the MF linked to demerit goods?

Answer 13

1) completely banning the worst of these goods
2) taxing relatively less-damaging goods – the level of tax reflects the level of the damage

Question 14

externalities

Answer 14

occurs when producer/consumer actions have positive/negative side effects on a third party

Question 15

draw a graph showing the community (consumer and producer) surplus and MSC and MPB

Answer 15

…

Question 16

Demand curve also represents…
Suply curve also represents…

Answer 16

…a marginal benefit curve.
…a marginal cost curve.

Question 17

MPB vs MSB

Answer 17

MPB - the benefit received is to the owner of the good
MSB - the benefit received is to the society

Question 18

MPC vs MSC

Answer 18

MPC - the created cost is to the owner of the good
MSC - the created cost is to the society

Question 19

If there are no externalities, the MPB and MPC (or MSC and MSB) curves…

Answer 19

determine the equilibrium P and Q where there is allocative efficiency (social optimum)

Question 20

If there is an externality…

Answer 20

there are benefits/costs for a third party causing the full society cost/benefit to differ from private ones

Question 21

Types of marginal failure

Answer 21

• negative externalities of production or consumption – production/consumption of a good/service creates external costs that are harmful to third parties
  – positive externalities of production or consumption – beneficial to a third party

Question 22

negative externality of production (NEP)

Answer 22

• production of a good/service creates external costs that are harmful to third parties
• e.g. factory releasing toxic materials, powerhouse burning fossil fuels releasing greenhouse gases (global warming)
  MSC > MPC
• good is overproduced so welfare loss present (MSC-MPC)

Question 23

how does G deal with NEP?

Answer 23

1) tax the firm to recover the external costs – shifts the S curve from MPC to MSC (decreasing welfare loss triangle area)
2) legislate to ban the firm or set environmental standards
3) issue tradable emission permits

Question 24

1) draw the NEP graph and point out welfare loss area
2) draw the same graph after an imposed tax

Answer 24

…
…

Question 25

Negative externality of consumption (NEC)

Answer 25

• consumption of a good/service creates external costs that are harmful to third parties
• e.g. secondary smoking, cars and air pollution.
  MPB > MSB (bc there is negative utility suffered by third parties)
• good is overconsumed so there is a welfare loss (MPB-MSB)

Question 26

how does G deal with NEC?

Answer 26

1) ban the consumption of the good/service
2) impose indirect taxes on the good/service
3) provide education and negative advertising to reduce demand for the good/service (e.g. images on cigarette packs)

Question 27

1) draw the NEC graph and point out welfare loss area
2) draw the same graph after an imposed tax
3) draw the same graph after negative advertising

Answer 27

…
… (increasing P)
… (reducing Qd)

Question 28

Positive externality of production (PEP)

Answer 28

• production of a good/service creates external benefits for third parties
• e.g. factory provides training for employees, society benefits from a new technology produced by a firm
• good/service under-produced and so there is a welfare gain
  (TC = COP + MC which society does not have to pay for)
• MPC > MSC

Question 29

how does G deal with PEP?

Answer 29

1) subsidy for a firm to reduce its costs
2) providing the product/service itself

Question 30

1) draw the PEP graph and point out welfare gain area
2) draw the same graph after an imposed subsidy

Answer 30

…
shifting of the MPC curve towards the MSC curve (both G actions)

Question 31

Positive externality of consumption (PEC)

Answer 31

• consumption of a good/service creates external benefits that are good for third parties
• e.g. getting vaccinated, using deodorant…
  MSB > MPB
• underconsumed = potential welfare gain (MSB-MPB)

Question 32

how does G deal with PEC?

Answer 32

1) subsidize the supply of the good/service
2) use positive advertising to increase D for the good/service
3) pass laws making the consumption of the good/service obligatory

Question 33

1) draw the PEC graph and point out welfare gain area
2) draw the same graph after an imposed subsidy
3) draw the same graph after positive advertising

Answer 33

…
shift of MSC down
shift of MSB to the right